(Bloomberg) -- Hedge funds are backpedaling on yen option trades with a sudden spate of bullish bets on the currency, according to market participants.

Just last month leveraged funds piled into option bets that the yen would fall back to 160 versus the dollar. That changed this week with funds now buying yen call options, which gain in value if the currency rises versus the greenback.  

The dollar-yen fell back below 155 on Tuesday after Bloomberg News reported that the Bank of Japan is likely to discuss the reduction of bond purchases as early as its policy meeting next week. The stronger yen has dimmed the allure of the carry trade. 

“Real money and tail risk funds have started to look at yen calls with some urgency due to the noise coming from policymakers onshore in Japan,” said Ruchir Sharma, London based global head of FX option trading at Nomura International Plc. “Concerns around possible quantitative tightening by the BOJ have spooked the market.” 

That’s not the only catalyst that has sent the dollar-yen tumbling. Disappointing US economic data has also weighed on the dollar by sending US yields lower. Traders are pricing in a greater probability of the Federal Reserve cutting interest rates by as much as 50 basis points this year.  

The increased demand for yen call options has resulted in higher premiums to hedge dollar-yen’s downside. The cost of hedging dollar-yen declining compared with rising over the next two weeks, which covers both the Federal Reserve and Bank of Japan policy decisions, rose to its highest level since April 29 on Tuesday. 

Dollar-yen is not the only carry trade that is experiencing a reversal of fortunes this week. The Mexican peso-yen trade was also upended following the nation’s election results. 

Carry trades have been “taken to the woodshed,” wrote Chris Weston, head of research at Pepperstone Group Ltd. A central theme in the past 24 hours of trading has been a “vicious unwind of Emerging Markets FX carry positions, where various election outcomes have driven an intense repositioning. At the epicenter of the flows has been MXN/JPY – perhaps the global poster child of a well-owned carry position,” he added.  

Investors are now focused on US ISM services data due later Wednesday, and the nation’s employment data on June 7, as they will feed into the US central bank’s latest dot plot due next week. If the data disappoints dollar-yen is poised to fall further as traders price in an even higher probability of at least two Federal Reserve rate cuts this year.  

--With assistance from Ruth Carson.

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